Will the Volcker Rule Survive The Midterm Elections?

By Simon Johnson

The Obama administration saved the deeply troubled megabanks in the United States in early 2009 with a bundle of rescue measures that, compared with similar financial crises elsewhere, stands out as extraordinarily generous – particularly to the bankers at the epicenter of the disaster.

The banks responded to this magnanimity with – by all accounts – extraordinarily generous support for the Republicans leading up to this week’s midterm elections. Why would they do this?

The answer is straightforward: The Republicans have promised generally not to tighten restrictions on the financial sector, which means specifically that they will seek to make the recent Dodd-Frank financial regulatory legislation less effective.

The Dodd-Frank Act is not strong legislation to start with. The administration started with overly modest goals, and the banks then devoted considerable effort to weakening the bill as it passed through the House. But some pieces that survived have the potential to make a difference – including the Volcker Rule, which in principle would force big banks to get out of the business of betting their capital in ways that can bring down the entire financial system.

Paul Volcker came up with the ideas and helped shape the original proposed rule. This provision was pushed hard by Senators Jeff Merkley of Oregon and Carl Levin of Michigan, who prevailed against the odds in getting it into the bill, but now find regulators less than uniformly enthusiastic about applying the rule.

This brings us to the details – where all relevant devils reside. That your eyes may glaze over, is, as far as the banks are concerned, a desirable feature, not a bug. Comments to the Financial Services Oversight Council on implementing the rule are due tomorrow; a few are already in, and more may be submitted at the last minute, in the hope of deterring rebuttal. (The banks can also rely on more private channels to make their views known.)

You can view the request for comment or search for the public submissions; when the site opens, click on the box for “public submissions” and a list of them will appear.

One comment, from State Street (on behalf of itself, Northern Trust and BNY Mellon), is instructive with regard to both substantive issues being debated before regulators and the broader political debate going forward.

The State Street argument is that the relevant section (§619) of Dodd-Frank could prevent a bank “from providing traditional directed trustee or similar services to its pension fund and other institutional clients.”

The issue, State Street points out, is “potential banks’ support for the investment performance of the fund” – that is, whether a bank would feel obliged to prop up the performance of a fund that is struggling. The problem with such propping up is that it will help a fund show better performance on average – and therefore help it attract more money – but it would also mean a bigger collapse, with much more devastating consequences, should subsequent problems arise (which is not so uncommon). Propping up is a fairly common phenomenon around the world.

State Street and its co-signers argue that banks such as themselves frequently do not have investment authority over plans for which they are trustees. But this is not the issue.

The real question is whether a custodial bank of any kind would have the incentive to prop up performance of a fund (of any kind). This is the way that banks can find themselves committing capital, whether they originally intended to or not. The sounder relationship between bank and fund is that when bad things happen, the bank is content to let the fund fail (or just show disappointing performance).

State Street and the other big banks mostly just want to be left alone. “We’re big boys and we can take care of ourselves” is their refrain – and you will now hear this echo far and wide, at least in the House of Representatives as we head into 2011.

This was exactly the operating philosophy of Alan Greenspan, circa 1997: “As we move into a new century, the market-stabilizing private regulatory forces should gradually displace many cumbersome, increasingly ineffective government structures” (quoted in “13 Bankers“).

The new century has not, so far, gone well, precisely because “market-stabilizing private regulatory forces” turns out to be an oxymoron.

And the specifics at stake here are far from hypothetical. Remember that Citigroup had large “off-balance sheet” housing-related liabilities that it ended up bringing back onto the balance sheet – thus absorbing the losses and forcing itself closer to insolvency. And even State Street had to prop up some of their “stable value funds”.

The designers of the details of the Volcker Rule – and their political masters – should not repeat Mr. Greenspan’s tragic and costly mistake. We need a real firewall between custodian banks and the funds with which they are connected in any form. The Volcker Rule, if properly and rigorously applied, can do just that.

An edited version of this post appears this morning on the NYT.com’s Economix blog; it is used here with permission.  If you wish to reproduce the entire post, please contact the New York Times.


7 thoughts on “Will the Volcker Rule Survive The Midterm Elections?

  1. As my daughter will say in a few years while texting thousands a times a day: ROFL

    Clearly, the war was lost. These small battles, even if won in the short term, will be undone later on when memory fades even further and propaganda continues to destroy any regulatory mandates.

    Just a footnote as to why beefing up regulation is a failed strategy as opposed to providing clear law on behavior a priori.

  2. Why are you mixing up a specific argument made by several large custodial banks (who did not need or want bailouts, though they were pressured into taking them) with the broader point that TBTF banks are fighting the Volcker rule (specifically) and regulation in general, and that they ponied up heavily to Republicans in this election to get their way?

    Usually you are way better than this.

    I could also add that there will be a helluva battle between the pro-bank side of the Republican Party and the anti-bank half. Tea Partiers have not even begun to contemplate where they stand on regulation, but I would dare say that they are temperamentally closer to Volcker than anyone else in Washington working on financial reform. They also may not be as averse to Elizabeth Warren as you imply. We really don’t know yet.

    Moreover, you imply that the thin-gruel of reform served up under Obama plus Dem-controlled Congress was worth saving. Or that Dems, had they been reelected in full force, would not have done something other than what you now accuse Republicans of wanting to do (i.e. gut the weak-ass legislation on the table).

    There was no appetite a month ago in Washington for strong reform measures. There may be little today. But this could change, depending on the populist winds that have been kicked up by the election. In this case, perhaps unusually, the lesson is not “follow the money” but follow the tea.

    If Obama is smart, and if he really wants to rein in the bankers (perhaps to punish his enemies), throw some red meat to his base, etc., he will push harder to get the Volcker rule implemented and Warren appointed. And he will challenge the Republicans to support him–or else be seen by THEIR base as altogether too friendly to the TBTF banks.

    In other words, go over the heads of the newly elected Republicans and appeal directly to the people. The people who hated the bailouts, hate the wall street fat cats, and remain very suspicious of the Republican establishment.

  3. Obama is such a moderate reasoning person that he didn’t see the obvious danger in rehabilitating his natural enemies when they were down.

    He’s reaped the harvest, and he needs to wake up and start making war on the looters and their shills (the knowing shills are the Republicans like Boehner; the unknowing ones are the Tea partiers).

    He’ll probably take a moderate course.

  4. This is a great piece, Simon. Good to have you working for us, although, thusfar, the Congress is ignoring all advice except that which they receive from those they are attempting (ha ha ha ha) to regulate and curb into becoming upstanding members of our country. Talk about lack of patriotism. We should try these b**stards for treason.

    (1991) Stephen Pizzo, Mary Fricker, & Paul Muolo

    Two Bush Bail-Outs Later; and the politics of keeping the looting swindle model undisclosed remains riddled in a conspiracy To Big to Solve. Part of the “systems capacity failure” dialogue is the distraction of arguing over regulation instead of demanding attention to the fraud perpetrated by deregulation. The scam worked twice and now you talk about closing the barn door so the industry doesn’t accidentally overstep itself again. Yes bring on the regulatory talk boys! And while your at it… a few more hundred thousand blindfolds too!

  6. Direct quote from the last page of the INSIDE JOB (posted above), written in the 1991 Harper paper edition well before the current fiasco:

    “And the money lost in the savings and loan crisis, as horrendous as it is, would pale beside a similar fleecing of the banking industry.”

    Little did they realize when they wrote those words that the reality of that very scope and scale would actually be realized. And few realize today that we are still paying for that bailout.

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